So, is the sky really falling? Or is a lone bird circling overhead, dropping nasty messages on our heads?
Does it really matter?
Assume, for a moment that Bear Stearns succeeds in efforts to buttress its two shaky hedge funds. Will the crisis be averted – postponed – or, fatally ignored as we whistle past the investment graveyard? As is usually the case on Wall Street, investor sentiment, and a nervous marketplace are likely to play a key role in the course of this predicament.
The Wall Street Journal recently pointed out that risky hedge funds have become heavily weighted with illiquid investments. In part, this has allowed hedge fund managers to value fund assets aggressively - using high-water marks for risky instruments and esoteric holdings. Portfolio managers benefit from this process when their compensation is keyed to fund value – the greater the assets, the higher the fees. But are some asset appraisals illusory and, if so, will funds eventually be called upon to answer for arbitrary valuations and possible conflicts of interest?
Hedge fund lenders could hold the key to this Pandora’s Box. Again, as the Wall Street Journal notes, when leveraged investments begin to suffer substantial losses, a fund’s lenders may demand more collateral or seek repayment of outstanding loans. Understandably, funds that invested heavily in complex securities backed by failing sub-prime mortgages are feeling pressure from the lenders.
It would be easy to dismiss the potential losses as just one more foreseeable risk assumed by sophisticated hedge fund investors. Unfortunately, repercussions are seldom so simple and victims are never that discrete. With cash flowing freely in recent years, a broad range of investors have jumped into hedge funds and their promise of even greater riches. Institutional investors, including pension funds and endowments reportedly have increased their investments in hedge funds and other less liquid instruments. Individual beneficiaries of those institutions may have little notion that their personal worth is tied to illiquid investments that could range from imaginative packages of risky real estate to timberlands. Or that a flash fire of creditor panic could jeopardize the value of their holdings.
Should we have seen it coming – as we looked up in the sky at the bird hovering overhead? Would investors be sufficiently forewarned if they if a fund were named “The Highly-Speculative, Riskiest Possible, Kiss Your Money Goodbye, You Need To Be Out of Your Mind to Invest” fund? Or like the cartoon Roadrunner and Coyote would they continue to race past the sign that says “Danger Ahead. Road Ends Here” and jump off the cliff?
And, if they do, who will catch them?
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